CPAs Predict More Audits of Small Businesses

The IRS is adding 2,200 new positions to its audit operations in 2005, reversing declines over the last several years. IRS audit personnel decreased by more than 25 percent between 1996 and 2002, the Associated Press reported.

"The feeling out there is that they have lost money over the years and they're trying to regroup," said Theodore Kravitz, CPA, with New York-based accounting firm ERE LLPP.

Even though the staff won’t be added until next year, agents can still look back at returns from the prior year. That’s why accountants are advising businesses to avoid putting anything into a return that could raise red flags, such as excessive expenses for entertainment, home offices and car usage.

Frank Lamanna, a CPA with Ison & Decosimo, a Memphis, Tenn., accounting firm, said many small business owners use a vehicle for both work and personal activities. Some try to take too big a deduction based on their business usage.

Another common red flag comes when taking deductions for a home office that is actually just a computer and fax machine in a corner of the bedroom. Expenses can be deducted for a home office, but it must clearly be an office.

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Kravitz said the IRS is putting a greater emphasis on matching copies of Form 1099s with income reported on returns. Discrepancies lead to an inquiry at the least, or even a full audit.

Corporations should watch out for too-large dividend payments that should actually be taken as salary by shareholders/employees of S corporations, Kravitz said. In an S corporation, profits are passed on to shareholders as personal income to them. Excessive dividend payments allow a business to avoid paying payroll taxes — for Social Security and Medicare — on the money, since the corporation considers it a dividend. But the IRS considers it salary. The company faces penalties and a possible audit.

In a C corporation, questions could be raised if the company pays too much compensation to employees, which would allow the company to avoid paying taxes on its own income.

Accountants say business owners should simply use common sense in deciding what to deduct, and when in doubt, seek the advice of a tax professional.